The U.S. Treasury Department's support of Popular Inc.'s (BPOP) quest to beef up its capital signals the government's interest in maintaining a strong lender in the troubled Puerto Rican economy.

Popular wants to add $1.1 billion to common equity in case the financial crisis gets more dire. But its attempt to beef up equity by converting privately held preferred stock and trust preferred securities into common stock initially failed to gain enough traction among trust preferred shareholders.

Last week, Popular announced that the Treasury Department would convert $935 million of Popular preferred stock it received through the Troubled Asset Relief Program, or TARP, into trust preferred securities.

The Treasury's decision to convert the preferred stock into trust preferreds gives little economic incentive to private trust preferred holders to convert to common stock, but the government is adding a psychological carrot: It appears to be assuring investors that the government has Popular's back, so to speak, encouraging investors to convert to common stock, several analysts said.

Popular, headquartered in San Juan, has been struggling with the island's four-year recession, and with the aftermath of its expansion into the mainland's banking and subprime-loan markets.

But Popular is Puerto Rico's biggest bank by assets and deposits. Popular is perhaps the most important bank on the island for the U.S. government to help maintain sufficient capital to weather the crisis.

Ten banks operate in Puerto Rico, and in 2005 many were burned when complicated mortgage derivatives deals turned out to be financially and legally flawed. Puerto Rico turned out to be the canary in the mortgage coal mine.

Popular was one of the few Puerto Rican banks that avoided this vanguard to the financial meltdown three years later. Popular Chairman and Chief Executive Richard Carrion is a director of the Federal Reserve Bank of New York and an executive board member of the International Olympic Committee.

Given Puerto Rico's precarious economic condition, and the damage many smaller banks have sustained there, government support for Popular stabilizes the island and avoids having "four million [Puerto Ricans] leave for Miami," said Bain Slack, an analyst with Keefe, Bruyette & Woods Inc.

On Wednesday, Slack upgraded Popular's stock to outperform from market perform. In his research report, he wrote, "Popular is using one of the few options it has left" to improve capital.

Popular, meanwhile, on Wednesday set the conversion prices of its common stock at $2.50. Popular's stock was recently ahead 3.4%, to $1.82. On Tuesday, the stock had jumped more than 31%.

The Treasury's conversion results in a $500 million accounting gain that is added to capital. Popular will avoid the embarrassment of suspending the dividend on government-owned securities - or converting them into common stock, as Citigroup Inc. (C) is doing.

Analysts and lawyers said this is only the second time that the Treasury agreed to convert its preferred stock; the first was Citi, where the government is converting its preferred into common stock.

Popular twice extended the conversion deadline - originally set for July 24, now August 20 - and sweetened terms of the conversion for private holders. It had already cut the dividend for preferred stock, and said it is "highly probable" that it would suspend dividends for the trust preferreds "for a number of years."

However, "As long as the TARP preferred stock remained outstanding, holders of trust preferred securities were likely to continue to receive their dividends," Joe Gladue, an analyst with B. Riley & Co. LLC, wrote in a research report. "This apparent assurance made them less likely to participate in the exchange offer."

-By Matthias Rieker, Dow Jones Newswires; 212-416-2471; matthias.rieker@dowjones.com